Do you occasionally have your teenage children or grandchildren helping you at the office on weekends, after school, or during their summer break? If so, you may want to consider putting them onto payroll. If you already have payroll set up for your company, adding your children should not be that big of a hassle. (However, if they just work once in a while, you might want to bypass the formalities and just add something to their allowance.) In addition, there is the added benefit of teaching your children a good work ethic and understanding the value of money.
Let’s review an example of the amount of potential tax savings;
- Income Tax
- Let’s take an example, your federal tax rate is 25%, and your state tax rate is 7% for a combined 32%.
- In comparison, if you hire your child/grandchild and you do the accounting right, they will pay no federal income taxes on the first $12,950 they earned in 2022. They will most likely pay very little state income tax, and even if they end up earning more, the federal and state tax rates will be relatively low.
- In this example, paying your child $12,950 saved you approximately $4,150 in income taxes.
- But wait, there is more; you can potentially save on social security and other tax as well!
- If your business operates as a sole practitioner (also known as a schedule C), or if you and your spouse have a partnership (or an LLC taxed as a partnership) and employ your children, you may save even more taxes. If the kids are minors, you won’t need to pay, and the kids won’t need to pay Social Security, Medicare, or FUTA taxes on their wages. Social security & Medicare is another 15.3%, so combined with the 32% savings, we’re up to a total savings of approximately $6,125!
Here is the procedure: The IRS allows any sole proprietorship or partnership (LLC) that is wholly owned by a child’s parents to pay wages to children under age 18 without having to withhold the payroll taxes and list it as “outside labor” as another expense. NOT Payroll. You do not have to issue a W-2. This is because there are no withholdings, and the penalty for not filing a W-2 is based on the ‘withholdings.’
If you issue a W-2 for your child, there are no FICA, FUTA, or SUTA due or withheld. We recommend a W-2 is if you plan to have your child contribute to a Roth IRA. In those instances, we want the IRS computer to match up to the kid’s contribution to the IRA with their earned income.
Be reasonable and make sure to have supporting documentation
Now that you understand the value of hiring your children, be sure of the following;
- The pay is reasonable and not excessive. Per the regulations, for any wage to be deductible, the amount paid needs to be reasonable. To be on the safe side, make sure that you pay the going salary. Don’t pay more than you would to an unrelated party who would have filled the job. If you have never had anyone in that position, ask around. An excessive salary is sure to raise a red flag. Tip to play it safe, pay your kids the minimum wage.
- Ensure that the children are suitable for the job
- Examples of jobs that are not suitable for kids – Fieldwork. State law requires anyone working in a dangerous industry to be at least 17, so if you run an auto mechanic shop, you can’t hire your 12-year-old to help you.
- Examples of suitable jobs – light office work. Your high school child can help you clean the office, stuff envelopes, do data entry, and light bookkeeping jobs. Etc.
- Child labor laws
- Federal Law – Children of any age, are generally permitted to work for businesses entirely owned by their parents, except mining, manufacturing, and any other occupation the Secretary of Labor has declared to be hazardous.
- State Law – some states have age restrictions on top of the federal law so make sure to check the specific labor laws in your state.
- If you have an S or a C-Corporation, you do not receive this benefit of avoiding FICA when paying your children. In this case, the only way to pay your kids tax-free is through a sole proprietor ‘management company.’ You do this by paying a legitimate management fee to the management company (Sole proprietorship or LLC) from the S-Corporation and then paying the children out of the Sole-Proprietorship or Single Member LLC.
- Some states do have a special standard deduction amount for someone that can be claimed as a dependent on another taxpayer’s federal return. For example, New York State for 2022 the amount is $3,100
Keep in mind, if audited, the IRS is quick to investigate family members’ payroll. If it’s clearly not possible that the child could have performed the work as claimed, the IRS will disallow the payments. Document everything. Keep a log of days and hours worked, what was done, etc.
Clearly, we’ve made it simpler than in real life. Be sure to discuss this with your accountant if this may apply to you.